The Intersection of Analysis and Governance

Following the sourcing, integration, and quality assurance steps of the governance journey, actual analysis can be conducted.

In this five-part series, FactSet’s Pat Reilly, Director of Analytics, examines the theme of data governance and distribution through the lenses of data sourcing, integration, quality, analysis, and distribution across internal and external clients. Combined, these provide asset managers and asset owners with an overview of the key elements to be considered when constructing an efficient data governance and distribution process.

Part four will tackle the theme of data integration and governance; the full series can be downloaded here.

And Now... Analysis

Following the sourcing, integration, and quality assurance steps of the governance journey, actual analysis can be conducted. Every firm, along with every investment team, has a different process based around asset class, mandate, benchmark, and client demand. There is certainly no one-size-fits-all approach.

Emerging market corporate debt is a good example of how proper governance can impact analysis. Sourcing appropriate security master data can be difficult, a variety of meta data is involved, generation and quality assurance of analytics require country-specific yield curves and assumptions, and alternative datasets can be additive to the entire investment process. The following analysis illustrates a deep dive into emerging market corporate debt, seeking to understand the attractiveness of the asset class via benchmark return series and returns-based analytics, constituent-level analytics, and issuer-level alternative data via FactSet’s geographic revenue content set.

The Emerging Market Debt Puzzle

The attractiveness of emerging market (EM) corporate debt, both hard and local currency, has received quite a bit of attention over the years. But does EM corporate debt fit into a broader multi-asset class portfolio? From a relative value perspective, the yield pickup during years of zero interest rate policy and quantitative easing in the U.S. and Eurozone markets was hard to ignore. Similarly, underwriting political risk against headwinds seen in developed markets painted a relatively rosy outlook. A primary takeaway was that worst case, EM corporate debt was a diversification play.

But is it? Like virtually every asset class, 2019 was a risk-on year for hard and local currency EM corporates. Hard currency corporates underperformed their U.S. counterparts while posting comparable returns to USD-hedged Sterling paper and outpacing Euro corporates, similar duration U.S. Treasuries, and local currency EM corporates. Historical returns also paint a picture of steady outperformance relative to other fixed income asset types.

However, a return series alone doesn’t tell the full story. Looking at the correlation of monthly returns over a five-year period provides additional required detail. First, a little surprisingly, we can observe that U.S. corporate debt has a very low positive correlation (.13) with the broad U.S. equity market. The correlation of U.S. corporates with Treasuries is expectedly high (.75), given that government term structure is an integral component of pricing corporate debt. Second, even more eye-opening, we see that EM corporates as defined by the JP Morgan CEMBI, are relatively highly correlated with U.S. corporate debt (.63) and are slightly less positively correlated with the broad U.S. equity market (.48). It is not surprising to see the diversification benefit of EM corporates relative to U.S. Treasuries (positive correlation of just .17).

There appears to be some diversification benefit to be gained from holding EM corporate debt, but does that alone make the asset type appealing? Let’s look at country spreads and relative value, term structure compared to U.S. corporates, and the international exposure of the broader U.S. equity market for a greater understanding of how EM corporate debt can help complete the puzzle.

Country Spreads and Relative Value

There are two relative value measures to consider when comparing country groupings in the JP Morgan CEMBI. The first is to take some sort of time series measurement (five years of month-end OAS levels in this case) and compare the most recent spread to that country’s long run average. The second is to compare the month-end spread to the spread of overall index. From here, the same exercise can be repeated at a security level.

Each of these measures allows for a rich/cheap analysis. One approach would be to compare a country’s current valuation relative to its long run average OAS. Another approach would be to compare a country’s current valuation to all others present in the index. Of course, countries and credits may be cheap or rich for a variety of reasons, so it’s irresponsible to look at this in isolation.

The next step would therefore be to underwrite each country in terms of endogenous factors like the macroeconomic environment, political risk or stability, and demographics. Sectors and individual issuers would follow a practical credit analysis.

In terms of EM corporates, little is attractive when credit is first measured historically. Brazil, Mexico, Colombia, and Indonesia all look rich relative to their historical valuations. China appears to be slightly cheap-to-fairly-valued relative to its historical spread levels.

From a relative value perspective, EM corporates are a mixed bag today, regardless of the diversification impact.

Term Structure

It is also important to understand our exposure across the yield curve to understand if the structure of the market could impact outcomes in varying market environments. U.S. corporates have greater interest rate risk relative to EM corporates (the ICE BAML U.S. Corporate index effective duration is 7.49 versus 4.47 for the JP Morgan CEMBI).

Exposing the key rate durations, we can observe that the U.S. index has far greater relative exposure to the long end of the yield curve while EM corporates tend to exhibit clustering around the belly of the curve.

Reviewing other summary characteristics also illustrates another appealing aspect of EM corporate debt: an additional 152 bps of yield. Combining the yield pickup with lower interest rate sensitivity lends credence to the attractiveness of the asset class.

U.S. Equity Market International Exposure

The final angle in the analysis pivots from a quantitative approach to a qualitative approach. On its face, the question of “do EM corporates provide a geographic diversification play relative to developed markets?” would seem easy to answer.

To investigate further, we can look at an alternative dataset such as the geographical revenue exposure of the Russell 3000. GeoRev accounts for primary and secondary disclosures before applying a GDP-weighted algorithm to determine country, region, or economic exposure regardless of company domicile.

Virtually 100% of the issuers in the Russell 3000 are domiciled in the United States. Over 64% of the Russell 3000 revenue is derived from the United States while 82% is derived from developed markets. Only 15% of revenue is derived from emerging or frontier markets.

Completing the Puzzle

Having taken historical returns, valuation, term structure, and geographic exposure into account, what is the conclusion around the attractiveness of emerging market corporate debt? As an asset class, it tends to have some value as a diversification play providing greater income generating potential with less interest rate risk. The flip side of that argument is that when importing yield, you may also be importing unattractive issues or issuers from a valuation or geopolitical exposure perspective.

There are certainly appealing characteristics of EM corporate debt, however each use case needs to view the asset class in the context of their risk tolerance; buyer beware.

A sound governance framework incorporating sourcing, integration, and quality provides a format to conduct top down and bottom up analysis across asset classes. While the above example utilizes an on-platform tool kit, the same analysis could be conducted off-platform and then delivered to internal or external clients for consumption via effective distribution mechanisms.

The information contained in this article is not investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.